The Securities and Exchange Commission (SEC) has proposed a set of reforms about open-end funds’ liquidity management programs.
The agency explains that it is proposing a new rule 22e–4 under the Investment Company Act, which would require mutual funds to establish liquidity risk management programs. Under the proposed rule, the principal components of a liquidity risk management program would include a fund’s classification and monitoring of each portfolio asset’s level of liquidity, as well as designation of a minimum amount of portfolio liquidity, which funds would tailor to their particular circumstances after consideration of a set of market-related factors established by the SEC.
John Hollyer, global head of Vanguard’s Investment Risk Management Group in Malvern, Pennsylvania, explains that a fund’s liquidity is not just in cash, but also securities that can easily be converted to cash, such as commercial paper or government bonds. Under the SEC’s proposed rule, funds will have to describe what securities will make up the fund’s liquidity and how much of each security the fund will hold at a minimum.
Hollyer tells PLANADVISER that Vanguard is concerned that the security classification rules are much more restrictive than what is required currently. “The SEC is asking for much more accuracy than mutual funds can know, for example, how many days it will take to settle a specific bond,” he says. Vanguard has concerns that the selectivity of securities based on liquidity will differ among funds and it will affect the ability to compare asset managers.
In addition, Hollyer says these requirements will be complex and costly for mutual funds, while not giving the SEC more insight on the level of security risk. “They need to justify what is required is worth the expense and burden,” he states. Vanguard has expressed its concerns in a comment letter to the SEC, but Hollyer notes that Vanguard supports the SEC’s efforts to have funds establish a top-down board-approved liquidity management program.NEXT: Will retirement plan sponsors and participants see any effect?
For plan sponsors, Hollyer notes, mutual funds have a very strong track record of managing risk and liquidity. “So you could argue that plan sponsors have been well-served by regulations so far, and depending on the final form of the new regulation, sponsors could benefit from knowing firms have higher standards for risk management,” he says.
“If mutual funds were less fully invested in the market because of liquidity requirements, that could be a detriment, particularly to long-term investors,” Hollyer adds. And, there could be the potential for increased costs passed to investors by mutual funds, but all this depends on the final form of the regulations after the SEC has considered comments.
In order to provide funds with an additional tool to mitigate potential dilution and to manage fund liquidity, the SEC proposed amendments to rule 22c–1 under the Investment Company Act to permit funds—except money market funds and exchange-traded funds (ETFs)—to use ‘‘swing pricing,’’ a process of adjusting the net asset value of a fund’s shares to pass on to purchasing or redeeming shareholders more of the costs associated with their trading activity.
Hollyer explains that this means when cash flows in or out rise above a certain threshold, the mutual fund could choose to adjust the cost of the fund that day to account for the number of investors who bought or sold on that day. Long-term investors, such as retirement plan participants, would benefit from this because they would not bear the cost of frequent traders.
Hollyer notes that in response to the global financial crisis there have been a variety of initiatives to improve the management of systemic risk across the nation’s financial system. In late 2015, the SEC mapped out a program of five things it would do in overseeing management of the mutual fund industry. The reason the SEC puts importance on liquidity risk management, is that mutual funds offer daily redemption as a feature. There has been a track record of more than 75 years of successful regulation, he says, but in response to the global financial crisis the SEC is making an effort to make sure risks are fully understood.
“I think the most important thing is to remember is that the mutual fund industry has benefitted from sound regulation and there really has not been a problem with having adequate liquidity. This represents an effort to go to a higher level,” Hollyer concludes.